The Hutton Series at Panmure House has proven an excellent foundation for a broad discussion about the topic of climate change, and how governments, organisations, businesses and households will need to adjust in the coming decades – voluntarily or involuntarily. In this article, I would like to explore in more detail one particular aspect of how such transformational change can be brought about.
Report after report has demonstrated to economists, policy makers and the general public that we are not pricing correctly the true cost of many of the goods and services which we consume. In the economic jargon, externalities are a growing problem. Nowhere is this more obvious than in the price of carbon. It needs to be higher, a lot higher, and very soon.
Since the industrial revolution began about the time of Adam Smith, fossil fuel consumption and the production of certain commodities and services have released an estimated 1,611 billion tons of carbon dioxide to the atmosphere, a 46% increase, according to NASA. An intellectual tipping point was reached a few years ago, when the consensus of scientific opinion concluded that urgent action is required if humanity is to limit the rise in CO2 over the next 30 years to levels which will prevent the global temperature rising by more than 1-2 degrees centigrade. With COP26, the next United Nations Climate Change Conference, approaching here in Scotland at year end, governments are under pressure to produce detailed plans on how to achieve this.
The good news is that governments already have many of the necessary tools, as a number of speakers have mentioned in the Hutton series. These are not only technological, say carbon sequestration or smart grids, but also the price incentives which will work in a market economy. Particular examples are carbon taxes, border adjustment policies, carbon credits and carbon emissions trading systems. The bad news is that current versions of these incentives are far too limited in scope. If externalities are to be tackled, then many aspects of society, how and what we consume, and hence what is priced into our pensions and investments, will need to change dramatically.
There are over 60 carbon tax and emission trading systems around the world. However, they are restricted both in terms of the countries which they cover and the industries within those countries. The continent of Europe does relatively well, and road transport, electricity generation or heavy industry are generally covered. Yet carbon pricing schemes are limited in the following countries – China, India, Japan, Russia and the USA - which emit the majority of CO2 emissions. In sector terms, many obvious areas such as air transport, marine shipping or agriculture need to be included. Hence the estimate is that such carbon schemes only cover about 22% of global greenhouse gas emissions (still only 40% even in the EU).
Political headwinds are obvious even before technical obstacles are examined. Households do not like higher energy prices, businesses resist higher taxes. Here in the UK, successive governments have failed to increase the fuel duty for eleven years. Consequently politicians often prefer regulations, such as fuel efficiency rules for cars. A further problem is the extensive use of energy subsidies, globally costing $5.2 trillion on IMF estimates. Border adjustment mechanisms are particularly difficult. On the one hand there are environmental risks, say from importing cheap steel produced using highly polluting coal fired power plants overseas; on the other hand a carbon border adjustment (CBA) policy is akin to a tariff and hence subject to pushback. This can be both at corporate level and also international; the USA has made its opposition to the proposed EU CBA very clear.
Can we calculate the price which would start to reduce some of these environmental externalities? Yes. The price of carbon does vary widely from country to country, scheme to scheme. However, the IMF calculates the global average price as only $2/tonne CO2. Where should it be? Much higher, according to the following organisations: the High-Level Commission on Carbon Prices suggested at least $50–100/tCO2 by 2030, an OECD report suggested $120, while the 2018 Intergovernmental Panel on Climate Change estimated that an effective tax would need to be at least $135. That is just 2030; BP suggests the 2050 price could be $250 on some scenarios. Of course, the ‘correct’ figure will vary from country to country. The tables below show a series of calculations by the IMF on the impact of different carbon prices on various major economies.
All charts are sourced by International Monetary Fund staff calculations and you can obtain their corresponding reports below:
Think tank after policy report after research paper has drawn this issue to the attention of governments. Indeed it is possible we may see a flurry of announcements in 2021. The IMF is launching a Climate Change Dashboard, Biden is planning an Earth day climate summit on April 22nd, the European Commission’s formal proposal for a carbon border adjustment (CBA) mechanism is expected in June, Boris Johnson has suggested a discussion about carbon at the G7 meeting in July. In a post Budget report, the UK’s Confederation of British Industry argued “A tax system which discourages polluting behaviours and rewards greener alternatives is critical to unlocking the right kind of investments”, whilst Jerome Mayhew MP has called for a CBA in the UK. The good news is that markets are starting to pay attention to these issues. The European Union’s Emissions Trading System recently saw a price of €40 per tonne, compared with figures closer to €5 back in 2016-18.
If we turn to the two largest economies, however, the situation is more worrying. Although Biden talked about carbon prices ahead of the election, his Energy Plan currently focuses more on energy efficiency standards, clean technology subsidies, and public funding for clear energy infrastructure. The IMF has suggested that a carbon tax rising to $50 per ton by 2030 would cut CO2 emissions in the USA by 22%. The political obstacles are clear, especially in states where the energy sector is important such as Texas and Virginia. So are the geopolitical issues – in a recent visit to Europe, John Kerry, Biden’s climate envoy, warned the EU to wait until after COP26 to see if a CBA was required. Turning to China, although it has committed to peaking CO2 emissions before 2030, there was remarkably little detail in the latest 5 Year Plan to bring this about; a national carbon trading scheme remains under development, and the amount to be traded looks likely to be a small percentage of the 10 billion tons of carbon annually emitted by China. Analysts report an understandable battle between central and local government, for example over further investment in coal fired power plants, against a backdrop of a sharp increase in carbon emissions in the second half of 2020.
As well as considering ‘externalities’, now is also a time for economists to carry out cost-benefit analysis. Increasing the price of carbon should incentive less usage and the transition to climate friendlier alternative energy sources. The Financial Times reported research by consultants Planetrics, which estimated that a carbon price of $100 would wipe about $2tn (close to 4%) off the market capitalisation of the 1,000 largest listed global companies. The 100 least resilient firms would lose just under half their market value. On the other hand, the best performing 100 would see their market values rise by nearly 30% - an important conclusion for investor portfolios. The IMF estimated that the previously mentioned carbon tax in the USA would raise revenue worth about 0.7% of GDP a year. This could be used to offset regressive tax effects of higher energy prices on lower income households, or it could stand alongside a wealth tax which the Biden administration is considering to fund a badly needed infrastructure programme. Indeed, a 2019 report by Canada’s Ecofiscal Commission concluded that using carbon pricing led to a better GDP per capita outcome for citizens than would policies based on regulation or subsidies. A planned carbon price “floor” in Canada will progressively rise from C$40 per ton in 2021 to C$170 per ton by 2030 (about $30 to about $100 in US dollar terms), intended to help cut nationwide CO2 emissions by about 33% below business-as-usual levels.
Over the longer term, the costs of climate change are poised to be far greater than the costs of taking action to avoid them. Looking at the global economy, the Intergovernmental Panel on Climate Change estimated that even with temperatures rising by 2 degrees, the loss to annual GDP growth rates could be of the order of 0.2%-2.0%. Others have warned of higher figures if a tipping point is reached, with much of the burden falling on the less developed economies. These are only the direct economic effects, when much of the fallout would be seen in terms of the stress on ecosystems and biodiversity, the effect on health systems and pressures on migration, or the exacerbation of geopolitical tensions.
Carbon pricing is an idea whose time has come; the world needs to make sizeable progress towards lower emissions over the next decade, and in a market economy so price incentives can be used to affect consumption and investment decisions. Indeed in January 2019 more than 3,500 economists signed the Climate Leadership Council’s statement calling for a carbon tax as “the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary.” However, recent progress has been far too slow. The outgoing Secretary General of the OECD, Angel Gurria, stated “carbon taxes are a necessary, if not on their own a sufficient, measure to abating the rise in carbon. We simply cannot afford, economically or environmentally, to get these policies wrong”. Sadly, such a statement was made five years ago.
What does carbon pricing have to do with Panmure House and Adam Smith? Certainly, while Smith was alive, the Industrial Revolution was in its earliest phases, ‘dark satanic mills’ were not yet a major feature of the landscape, and externalities arising from environmental pollution not top of his mind. In the Theory of Moral Sentiments he wrote about:
‘the industry of mankind…. [has] entirely changed the whole face of the globe, … turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth (p183)’.
Time has moved on, and the impact of humanity even more so. The population of the planet was closer to 700 million in Smith’s time than today’s 7 billion. However, Smith’s writings do indicate that he was well aware that people often make fundamental mis-judgments about means and ends, and the benefits of positive externalities, say from education, were a topic he did write about. The ‘invisible hand’ could not solve all mankind’s needs, hence certain public goods were required. What better positive externality could there be than a true price of carbon which brings about a better planet for our children and grandchildren?
About the Author
Andrew Milligan is an independent economist; he was a member of Court at Heriot Watt University until 2019, and Head of Global Strategy at Aberdeen Standard Investments until retiring in 2020.